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Looking into 2017

Hermes Investment Management Outlooks

The election of Trump, and the vote for Brexit shortly before that, clearly indicate that for a large number of citizens in the UK and the USA, the ‘system’ had failed them to such an extent that they were willing to take a leap into the unknown and opt for profound change. I would argue that the reason why the system failed so many is to do with the anaemic growth since the crash of 2008 and in the UK drive for austerity. This combined with profound and fundamental changes in productivity due to technology, which along with globalisation and cheap immigrant labour combined in a way that prevented a very large part of the population from feeling any economic benefit since 2008 and gave them a deep sense of being ignored and left behind by the elite.

Looking forward into 2017, we can safely say that the result of both these events will likely increase political risk in developed countries. Specifically, the risk premia in Europe as we see how the Putin/Trump relationship develops and how it might affect Russia’s revanchist policy, as well as elections that will be fought in several European countries against a backdrop of the Brexit/Trump political upset. It may also create an increase of risk in the oil producing Middle East.

From an economic perspective, it seems that Mr Trump, with the support of both houses, is set to increase spend on infrastructure in the US as well as try to boost consumer spend by reducing the Federal tax rate. This stimulative policy implies an increase in US government debt. However, this positive economic policy might be countered somewhat by an avowed protectionist stance, sparking stagflation. The key question, though, is whether even with this capex and fiscal boost, the lot of ordinary blue collar workers and lower middle class families in the USA, can be much improved, if one accepts our premise of a permanent downshift in the natural rate of interest and a technology led change in productivity.

I think the right thing to do for long term investors is to ignore the noise and concentrate on the long term. A permanent downshift in the natural rate of interest would direct one to invest more in equities than in bonds and more in emerging equities than developed equities (although US small cap would be a beneficiary of Trumponomics).

However, the real worry is neither anaemic growth rates, nor possible inflation, nor even market volatility driven by hard to predict political risk. The real worry is that if Trump reneges on COP21, we as a species would be unable to prevent 2 degree warming, which is a long term negative for the generations to come.

Saker NusseibehChief Executive,Hermes Investment Management

2017 Outlooks by team

Investment

In a year of electoral shocks, everything is fine as long as nobody steals the punch bowl. But as time passes, there’s a growing sense that the punch may not be quite as tasty as everyone first thought, and its beneficial effects seem to be lessening with each mouthful. For ‘punch’ read the unconventional monetary policy gambit taken by the world’s central banks.

In a world of low or zero interest rates, two central pillars of investment, namely valuation and asset allocation, become incredibly difficult. All risk assets benefit from the additional liquidity that is pumped into the system, and it is hard to distinguish them properly on fundamental grounds. Beyond that, low interest rates and low growth direct us to a future of incredibly low expected returns relative to the last 30 years, creating a challenging environment for any investor to reach their return target.

Risk, at least in terms of headline volatility, is suppressed. This could lead investors to become complacent and allow more leverage to creep into the system – until the next shock, that is, when once again the markets will reveal themselves as fragile and liquidity risk will be at the fore (beware corporate bond ETFs). Fortunately we know that risk is so much more than volatility, and the various metrics that we study – correlation risk, stretch risk, liquidity risk and event risk – will help us to navigate the treacherous waters of 2017.

Macroeconomic

Central banks daren’t lift the tide of liquidity hiding the sharp rocks beneath, with loose-for-longer policies having many years left to run. Official interest rates will stay close to the floor, while political risk – largely absent in the 2008 crisis – is building. My outlook is based on four beliefs.

First, not only will US and UK real policy rates stay negative, but ‘peak’ rates when they come will be much lower than we’re used to. Nine years after the first traces of crisis, we have a two-speed recovery. The leaders include the US and UK. But, still in the slow lane are Japan and the euro-zone, which have space for some fiscal support in 2017. The question after eight years of quantitative easing amounting to $13tn is how central banks can turn off their liquidity taps without unintended consequences. Their skin in the game via bloated balance sheets suggests they cannot take us by complete surprise.

Second, should protectionist forces build, from the US to Europe, inflation will reappear. But, by being the wrong sort of inflation – cost, rather than demand-led – central banks will turn a blind eye.

Third, China is slowing, but has the wherewithal to soften the landing. The leverage and deflation effects need watching, providing another reason for the Federal Reserve to tread lightly.

Fourth, without convincing recoveries, any contagion, unlike 2008- 09, may be political rather than financial. Hopefully, governments in 2017 will help avert this by offering fiscal solutions – taking the policy baton back from the central banks.

Equities

Politics and populism dominated headlines in 2016. For markets, a collective shift in perception from secular stagnation to global reflation was the main event. Monetary accommodation, as authorities’ policy tool of choice, was replaced with expectations of fiscal stimulus. Next year, politicians will be challenged to make this hope a reality and markets tested whether they are ready to kick their addiction to monetary largesse.

Market participants have flirted with hopes of economic recovery since the financial crisis only to be confronted by decelerating global growth. Quantitative easing has kept asset prices buoyant but economic activity has often failed to keep pace with indices, contributing to bouts of intense volatility and growing disillusionment about the efficacy of monetary policy.

While 2016 began with a collapse in confidence about global growth, 2017 should see improving expectations for demand. Already global trade is dragging itself out of the summer slump, with exports in all major regions strengthening. But hidden in the improving economic data is an implicit threat: for markets that have thrived on monetary stimulus, the risk of higher bond yields and rising inflation weakens equity valuations. A stronger US dollar would also summon the spectre of tightening liquidity and undermine commodity prices. Elevated debt levels will test the resolve of the Federal Reserve to normalise official interest rates – especially if politicians fail to provide fiscal stimulus.

The message for markets in 2017 is simple: be careful of what you wish for. Hopes for a new policy order may prove too optimistic, and will present challenges even if they are fulfilled.

Global Equities

Looking ahead, one of our main concerns is the impact of pricing pressure on the healthcare sector. Pharmacy benefit managers are squeezing the margins of drug manufacturers, while a price war has erupted among distributors, undermining profitability as the industry adjusts to a new environment. Companies with limited ability to innovate will struggle and there will be an increased pressure on companies relying on patents and price hikes to grow earnings.

Elsewhere, the rhetoric from the European Central Bank has lately become more hawkish, and with the Federal Reserve seemingly intent on raising official interest rates, bond yields have started to increase in Europe and the US. This poses a big risk to sectors such as utilities and consumer staples, which have been sought for their bond-like income streams. Rising yields have hit major oil companies, which could be further challenged by a low and range-bound oil price as US shale producers can only start turning on the pumps when the oil price approaches $55 and OPEC has yet to confirm the scale of its agreed cut in production.

Political risk is also at the forefront of many investors’ minds. We believe the risks are exaggerated. This is not to downplay its importance: rather, it is to acknowledge that companies will continue to operate regardless of election or referendum results, and the best will adapt successfully to changes in the business environment. As such, we remain steadfastly committed to identifying attractively priced companies that are well-run and have demonstrated their ability to grow sustainably, while minimising our exposure to macroeconomic risks.

Emerging Markets

At the beginning of the year we thought the performance of emerging markets would strengthen, and indeed that has been the case. Profitability hasn’t caught up with stock prices yet, but a range of other indicators are positive: the GDP growth differential between emerging and developed markets is widening, and in the emerging world capex and labour costs are declining, estimate revisions have stopped falling, free cash flow yields are attractive, commodity markets have recovered their composure and investor positioning remains light. At the country level, Russia and Brazil should exit recession in the coming year, most Latin American nations are governed by market-friendly administrations, Chinese growth has confounded the bears (albeit at the price of ever more indebtedness), and India’s economy should begin to heal as banks repair their balance sheets and the agricultural sector recovers its poise after several years of drought.

Therefore in 2017 emerging market companies should become more profitable, though emerging market countries will become more differentiated. Carry trade economies (Brazil, Turkey, Indonesia and South Africa) will continue to experience competition from higher US bond yields. For exporters (Mexico, China, Korea, Taiwan), we expect renegotiation rather than rejection of existing trade agreements as the “Master of the Deal” shows the world how it’s done. Great companies with great business models, wherever they are, should find the economic environment supportive in 2017. Those countries avidly pursuing economic reforms will emerge much stronger from the current uncertainty. Valuations are once more very supportive of emerging markets, so we are constructive for the coming year.

Asia ex Japan

In our outlook for 2016, we expected a re-rating of Asian cyclical stocks relative to defensives. So far this year, we have turned out to be both right and wrong: the standout performers in the universe were largely limited to the so-called deep defensives, such as consumer staples stocks, but also the deep cyclicals like energy and materials companies. What did not perform as well were what we term quality cyclicals, which we define as companies with cyclical earnings that remain profitable even in down cycles, companies that typically experience shallow down cycles, have low debt and generate a good average return on equity through the cycle. Such stocks tend to be found in the industrial and consumer discretionary sectors – which have underperformed year to date. Given that many stocks in these laggard cyclical sectors are still attractively valued, we believe that quality cyclical companies offer the best value in our market despite their mixed earnings outlooks.

European Equities

The majority of the companies we invest client assets in today have endured eight years of economic and political turbulence. Many of the concerns that investors have today are similar to those we faced in 2012 and 2008. As we said at those junctures, we prefer to listen to companies’ messages of cautious optimism, of opportunity rather than risk. Investors remain fixated with policy decisions though creating volatility as large swathes of the market correlate with moves in yield curves and currencies.

Our approach seeks to cut through the noise by focusing on the delivery of earnings and cash flows which will ultimately drive individual share prices. This requires patience though and while Europe may not resolve its problems in the near future, the message we hear from companies leaves us far more optimistic as investors. Most are comfortable with their outlook for European demand, which remains unchanged. If there was a concern it lay with the US business cycle.

The continued focus on election and referendum polls, and what could cause the next “Lehman moment” has resulted in persistent outflows from Europe, which also creates anomalies at the stock level leading to exciting investment opportunities. So, no matter how Europe looks in the years ahead, we feel confident that many companies will continue to exercise control over their own destinies and thrive. Investors who recognise this will be rewarded, highlighting the importance of having a flexible, logical and forward looking mind-set, coupled with an active approach to managing clients’ assets.

Small & Mid Cap

The prospect of rising interest and inflation rates is currently prominent in the minds of investors and will persist into 2017. The market impact is clear, with two examples being the units outstanding in the biggest US low-volatility exchange-traded fund, which reached their maximum level in July, and the S&P500 Real Estate sector, which has underperformed sharply since peaking at the same time.

The animal spirits of the market seem to have finally tired of bond proxy stocks, which has extended well beyond the utilities and telecommunications sectors, and this is a very welcome development for us. It will result in attractive entry points into companies with solid long-term growth stories that we seek. History has shown that relatively defensive stocks that benefit from strong barriers to entry and secular growth characteristics can keep up with rising markets, yet outperform in adverse environments, thereby producing good risk-adjusted returns throughout the cycle.

The early stage of a rates cycle is typically good for small caps, as it implies improving economic conditions. Indeed, in Europe at least, they demonstrate their strongest absolute returns when the yield curve on long-dated government debt is sloping upwards – and is steeper than it currently is. We advise investors to keep a close eye on long-term rates in 2017 – a steepening curve should be the sign of a healthy economy but could cause problems for leveraged investors.

Small cap stocks have outperformed large caps in all regions this year. It is reasonable to expect this to continue given the current low-growth environment. There is tail risk to the downside if contagion spreads from even a small number of participants getting caught out by the unforeseen effects of a rate rise, and previous central bank intervention for that matter. However, with a low-beta portfolio we should preserve capital to prosper another day.

US Small and Mid Cap Equities

The dramatic shift in US leadership has fundamentally changed the outlook for domestic small- and mid-cap (SMID) stocks. Markets have responded positively to pro-growth policies put forward by President-elect Donald Trump, namely spending $1.2tn on infrastructure and slashing the corporate tax rate from 35% to 15%.

Such policies are likely to proceed given the Republicans’ control of Congress, and in time should boost growth and inflation in an economy that was already strengthening – US real GDP increased at an annual rate of 2.9% in Q3, more than doubling the pace of growth recorded in Q2.

US Treasury bonds have already sold off on the near-term prospect of the Fed raising the benchmark interest rate in December and the long-term risk of higher inflation, and another two rate hikes in 2017 are likely. This bodes well for SMID stocks, which tend to outperform large caps during tightening cycles.

There are also two further reasons why US SMID companies are now particularly attractive: industry exposures and relative valuations.

US SMID stocks typically have a 70% to 80% exposure to the domestic economy, compared with 50% for large caps. They are also substantially more active in the industrial and financial sectors, and should generate stronger relative earnings momentum due to increased infrastructure spending and the margin-boosting effects of a steeper yield curve and higher short-term interest rates.

Given these powerful fundamental drivers, US SMID stocks represent good value. Their current premium of a 1.1x price-to-earnings multiple over larger large caps is lower than the long-term average of 2x, suggesting that the market has not fully factored in the strength of the growth outlook for these companies[1].

We believe that these favourable conditions for SMID companies will make the US a land of opportunity for stock pickers in 2017.

Credit

From the middle of March of this year, global credit markets inexorably tracked a positive trajectory. However, what has been notably absent from the many factors that drove spreads tighter is macroeconomic momentum. Consequently, as we look into 2017, we believe that focusing on the fixed-income characteristics of credit management will be essential to outperformance. For example, since the traditional inverse relationship between risky assets and government bonds has weakened in the last few years, a continued reliance on that historical lack of correlation in 2017, when global rates remain at historic lows, would be a mistake. For the purpose of protecting capital, it makes sense to reduce exposure to duration and build defensive strategies from credit risk instead.

The global hunt for yield, combined with widespread low interest rates, has prolonged the life of moribund companies, leaving creditors with minimal residual recovery values when those companies finally collapse. Because downside risks are now far greater than in the past, we do not believe that gambling with default risk to deliver performance makes sense. Rather, having the flexibility to capture valuation anomalies that emerge when looking down to security level across credit markets on a global basis, is a better way to generate strong risk-adjusted returns. Despite this year’s rally, we see plenty of opportunities in 2017 but must reject traditional credit management methods and instead cut our own path.

Private Debt

In 2017, the features that characterised the European loan market in the second half of this year are likely to persist. These are: strong competition among lenders, reduced primary M&A transaction flow that is somewhat offset by increasing refinancing volumes, and the continued low default rates.

Against this background, mid-market loans will continue to offer investors better value compared to large cap loans. Lenders to large companies will continue to compete against capital markets at a time when there is plenty of liquidity chasing fewer transactions with diluted loan terms and lender protections – a sign of the increased structuring of ‘cov-lite’ deals.

In contrast, the mid-market remains attractive for investors, driven by the continued presence of bank lenders due to long-established relationships, resulting in more disciplined loan characteristics. With increased regulatory oversight of the banks, it is unlikely that there will be a significant loosening of lending terms in the European mid-market next year.

The uncertainty created by Brexit should continue to bolster yields in the sterling leveraged finance market, with the euro-sterling yield differential continuing to favour the depreciated UK currency. We believe that Continental European banks will be less active in the UK due to sterling funding pressures. With currency weakness making the relative value of UK assets more attractive to international private equity investors in the medium term, transaction flow in the UK should remain healthy.

Loan defaults should remain low as companies continue to benefit from persistently low interest rates and a benign economic environment. Nevertheless, an ability to originate high quality loans will still be a significant competitive advantage for direct lenders.

Multi Asset

After 25 years of falling inflation and the apparent failure of quantitative easing to lift the costs of goods and services in recent years, inflation has probably not featured in most investors’ lists of top three risks for some time. Furthermore, inflation tends to be associated with growth, allowing investors to focus on the latter. However we believe that economic environments are best characterised by the interaction between growth and inflation, making it prudent to consider inflation protection at all times.

The stabilisation of commodity prices and the fall of sterling alone are likely to boost UK inflation through the first half of 2017. Over the medium term, the government seems willing to use fiscal policies to spur growth, which could impact the economy more than quantitative easing has so far.

In addition, major central banks have stated their intentions to ignore next year’s expected overshoot by inflation of official targets. Their belief is that ultra-low rates supply plenty of ammunition for fighting inflation. However, if they face a dilemma between fighting inflation and supporting growth, they may be reluctant to tighten, which could further boost inflation expectations. This in turn is likely to cause a significant re-pricing across all asset classes.

History shows that in a reflationary environment the correlation between bonds and equities is likely to turn positive. We will consider this when making investment management decisions, alongside specific tools, such as cross-asset momentum and relative-value strategies, to maintain a balanced portfolio. Given the rise in inflation expectations, we will maintain our long bias towards inflation hedges.

Private Markets

Real Estate

Investors’ appetite for real estate remains strong and shows few signs of abating in the short term. Global transaction volumes are at record levels, and performance has been strong across most regions. Real estate will remain an asset class of choice for generating income and delivering steady returns in a world of weak growth, low interest rates, quantitative easing and weak inflation.

Yield compression has driven pricing back to pre-financial crisis levels worldwide. Such pricing is not always supported by fundamentals, and many markets therefore look fully valued. Rental growth is expected to remain subdued in a low-growth environment where corporate occupiers face pricing pressures and tough trading conditions. Most markets are in the later phases of the pricing cycle, making it difficult for investors to find value in 2017.

We will continue to focus on developed markets, where the powerful forces of demographic and technology change, urbanisation and sustainability are creating a structural shift in occupier needs that provides opportunities despite higher pricing levels. These include:

New specifications for traditional spaces, both office and retail, to meet changing occupational requirements

Emphasis upon place-making, public realm and mixed use development

As the pricing cycle unwinds, it will be critical to invest in and develop real estate assets that can both meet the occupational needs driven by these forces and provide returns that satisfy investors’ objectives. In 2017 we will target such opportunities in major US cities and across Europe’s key markets, including the UK, while recycling capital to capture the benefits of diversification across other major real estate markets.

Infrastructure

Infrastructure remains an attractive asset class for many institutional investors, with allocations continuing to increase globally. With its ability to generate long-term, predictable, inflation-linked cash flows as well as provide attractive real rates of return, the asset class continues to play an important role in many pension funds’ strategies to meet their liabilities.

While the full domestic impact of Brexit is still unclear, infrastructure investors continue to target the UK, attracted by the essential services provided by the assets and the nation’s long-standing, transparent regulatory regimes. In the short term, monetary easing with lower-for longer interest rates should ensure that investors continue to focus on yield. Over the longer term, we expect fiscal stimulus to supplement monetary policy measures, which should result in new infrastructure investment that will provide opportunities to capture capital growth.

The breadth and depth of prospective investment opportunities remains and should allow us to continue to deploy £300m-£350m each year, which is consistent with our historic annual rate of new direct investment. Concerns such as ongoing government fiscal pressures, decarbonisation policies and security of energy supply will keep creating interesting investment opportunities in 2017 and beyond. Responsible investing, which aims to increase the quality of life for pensioners as well as generate strong financial returns, is an increasingly important part of infrastructure investment.

Private Equity

We believe that volatility and uncertainty in global financial markets is set to continue as we head towards 2017. The UK’s ‘Brexit’ vote and the unexpected US election outcome are manifestations of increased geopolitical uncertainty, as countries and populations struggle with the effects of globalisation and technological progress, as evidenced by the instability caused by unequal wealth gains resulting from structural changes in the global economy.

This is an environment where we favour alpha over beta as the main driver of return. Amid high valuations in core private equity buyouts, we strive to identify pockets of idiosyncratic, uncorrelated growth, both in growth markets in emerging economies, where attractive catch-up investment opportunities can be found, as well as in technology-enabled growth companies in the developed world. As we favour secular over cyclical growth, we aim to tap into structural mega trends that are expected to shape the global economic landscape over the next 15 years, such as urbanisation and a growing middle class in emerging markets or technological innovation and demographic shifts in developed markets.

We believe private equity offers purer and more direct exposure to these trends before they become accessible through public markets, allowing investors to build portfolios with distinct risk/return characteristics that are highly complementary to public markets portfolios. In the uncertain environment that will characterise 2017, an intelligent, global, active investing approach within the private equity asset class should continue to offer robust investment returns for institutional investors.

Responsibility and Stewardship

Pressure is rightly mounting on investment managers to help develop and participate in an investment industry that works more effectively for the beneficiaries it serves. As a result, we expect more investment firms, encouraged by asset-owner clients and industry organisations, to increase their engagement and advocacy activities. Next year may be too early for legislation requiring stewardship activities, though this may happen in the medium term.

With the improving quality of environmental, social and governance (ESG) data, investment managers will continue to collect and integrate more of this information into their investment processes. However we expect many investors will not regard ESG risk – even when it is material – as critical in most of their investment decisions. More attention will be paid to the carbon footprints of investment portfolios, as this is likely to be demanded by asset owners and governments following France’s lead with its carbon-disclosure law for institutional investors.

With MiFID II changing European Union legislation for firms providing financial instruments and associated services from January 2018, investors will need to be more transparent about their fees and expenses ahead of this date. As a result, we also expect asset owners to increasingly ask investment managers to justify their fee and remuneration structures.

Overall, we hope that there will be greater recognition, that investors’ role is not only to deliver an investment return for savers, it is also about engaging and advocating for a better economy and society for beneficiaries to retire in.

EOS

Stewardship codes and guidelines were introduced in a number of markets in 2016 – such as Brazil, Hong Kong, Singapore and Taiwan – as efforts to implement existing ones, like those in Japan and the UK, were intensified. As such, more investors will be faced with the task of effectively implementing stewardship across the globe.

In meeting these obligations, investors will continue to focus on getting the right people on corporate boards. Diversity, in its broadest sense, will be a particularly important matter. Investors with more resource will question how boards are discharging their roles and engage directly with executive and non-executive directors.

Following the second shareholder spring in 2016, which saw strong votes against proposed pay packages at a number of companies, remuneration will again be in the spotlight in 2017, particularly in the UK. Ourselves and other investors launched new remuneration principles in the second half of 2016, setting out expectations to help steer companies in the right direction ahead of the voting season.

Building on the 2015 Paris Agreement, environmental engagements with companies will continue to focus on the resilience of their portfolios to climate change and the results of stress-testing and emissions reduction commitments. After the success of shareholder proposals in 2015 and 2016, investors will continue to focus their efforts on companies facing material climate change risks.

Supply chain management and human rights will once again be key engagement subjects in 2017 following the introduction of legislation on modern slavery in the US and the UK in 2015.